GOOD CHOICES WHEN TO CHOOSE BETWEEN A …

[Pages:20]GOOD CHOICES: WHEN TO CHOOSE BETWEEN A GIFT ANNUITY OR CHARITABLE REMAINDER TRUST

NATIONAL CAPITAL GIFT PLANNING COUNCIL'S 18TH ANNUAL PLANNED GIVING DAYS CONFERENCE MAY 14, 2010

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Presented by:

Jeff Lydenberg Vice President, Consulting

PG Calc 129 Mt. Auburn Street Cambridge, MA 02138

617-497-4997 jeff@

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I. Introduction

The profile of those interest in life income gifts share many similarities. These individuals need income, they may want to save additional amounts for retirement or they may have tricky assets they would like to turn into a source of income. A charitable remainder trust (CRT) or a charitable gift annuity (CGA) both offer features that might meet the donor's objectives. There are other situations where one or the other is clearly preferable. The CRT and the CGA each have unique features that make one or the other the better choice.

The CRT and the CGA can be useful for situations when a beneficiary wants immediate payments, an individual is still working and wants a supplemental retirement plan, an individual wants to contribute real estate, or an individual wants to contribute closely held S or C stock.

II. Individuals Who Want Immediate Payments

A. Charitable Remainder Trust

CRTs are distinct from gift annuities in that a remainder trust is a legal entity separate and independent from the donor and the charity. The trust holds and invests the contributed assets, makes the specified payments and only on the conclusion of the trust term may the remaining trust assets be applied for charitable purposes.

All CRTs share certain characteristics:

? The trust donor is entitled to a charitable income tax deduction for the present value of the charitable remainder.

? The trust must be irrevocable and create a valid trust under local law. ? The trust must make payments at least annually to at least one non-

charitable beneficiary. ? The trust may make payments for the life of the designated beneficiaries

or a term not to exceed 20 years. ? The trust annual payment may be no less than 5% and no more than

50%. ? The trust's income tax charitable deduction must be equal to or greater

than 10% of the trust funding amount. ? The remainder trust charitable income tax deduction must be equal to or

greater than 10% of the donated principal. ? The payout to the trust beneficiary may be in the form of an annuity or

unitrust amount.

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Charitable Remainder Annuity Trusts A charitable remainder annuity trust (CRAT) must make a fixed payment of a specified dollar amount to the designated income beneficiary. The fixed payment must be no less than 5% and no more than 50% of the initial value of the assets transferred to the trust. The annuity trust's annual payment is based on the initial funding amount of the trust and remains constant throughout its term. Subsequent additions to the annuity trust are prohibited. It is not possible to defer payments from an annuity trust.

Charitable remainder annuity trusts are subject to the 5% probability test is described in Revenue Ruling 77-374 that requires all remainder annuity trusts that will make payments for one or more lifetimes to have less than a 5% chance of principal exhaustion. If a CRAT fails the 5% test, no deduction is allowed. It is also questionable whether the trust will qualify as a CRT. In 2008, 19,241 charitable remainder annuity trust tax returns were filed with the IRS.

Charitable Remainder Unitrusts A charitable remainder unitrust (CRUT) must make payments of a fixed percentage of the trust value as revalued annually to the designated income beneficiary. The payment each year is based on the then current value of the assets held by the trust. The unitrust's annual payment fluctuates from year to year based on the value of the trust each year. Subsequent additions to a CRUT trust are permitted.

If the CRUT's value goes up from one year to the next, its payout increases proportionately. Likewise, if the CRUT's value goes down, the amount it distributes also goes down. For this reason, it may be advantageous to choose a relatively low payout percentage so that the CRUT assets can grow, which in turn will allow the CRUT's yearly payments to grow. In 2008, 96,248 charitable remainder CRUT tax returns were filed with the IRS.

Individuals may be able to increase their cash flow with either a charitable remainder CRUT or a charitable remainder annuity trust. This happens when a donor contributes appreciated property that is generating little or no current income and the trustee sells the property and reinvests the proceeds. Since the trust is taxexempt (unless it has unrelated business taxable income), the entire sales proceeds can be invested to generate income.

Example: Jim and Patricia, ages 68 and 66 respectively, own stock having a fair market value of $600,000 and a cost basis of $250,000. The stock's annual dividend is $12,000. Compare the results of funding a charitable remainder unitrust versus a charitable remainder annuity both with a five percent payout rate.

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Charitable Unitrust 5%

Charitable Annuity Trust

5%

Gross Principal Charitable Deduction Total before-tax income Benefit to Charity

$600,000

$220,662

$973,587* $1,184,152*

$600,000

$159,798

$690,000 $1,696,079*

*Assumes 8% annual investment returns.

During the first year their income from both the unitrust and the annuity trust increases from $12,000 to $30,000. Their income from the unitrust in future years could be higher or lower, depending on whether trust assets increase or decrease in value. The annuity trust income remains at $30,000 per year for life.

Donors who prefer the security of fixed income over potential growth might choose an annuity trust rather than a CRUT.

B. Gift Annuity

A CGA , like a CRT, may enable a person to increase cash flow and save taxes while arranging a charitable gift.

Example

Barbara, age 75, has a $50,000 CD that is maturing. She could purchase another CD paying three percent, but instead she contributes the $50,000 for a CGA. Here is a comparison of her cash flow from another CD and the CGA.

CD Investment

Invested in CD Interest Income tax on interest (28% rate) Net spendable

$50,000 1,500 -420 $1,080

Gift Annuity Contributed for CGA

$50,000

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Annual payment (6.3%) Taxed as follows:

Ordinary income Tax-free Income tax (28% x $926) Net spendable

3,150

926 2,224

-259 $2,891

* At the end of her actuarial life expectancy, the annuity payments are fully taxable as ordinary income.

In addition to nearly tripling her cash flow from the $50,000 that had been invested in CDs, Barbara receives a charitable deduction of $22,440, which results in tax savings of $6,283.

It must be kept in mind that a CGA entails an irrevocable commitment of her principal to the charity.

C. Comparison

1. Advantages of a CRT.

? In the case of a CRUT, there is the potential for income growth to keep pace with inflation.

? There is no limit on the number of income beneficiaries, provided the charitable deduction is at least 10 percent of the contribution and, in the case of an annuity trust, the 5% probability test mentioned earlier is met. By contrast, there can be no more than two annuitants of a CGA.

? The trust remainder can be divided among any number of charitable beneficiaries, and the donor can reserve the right to change these beneficiaries. The contribution for a CGA becomes the property of the issuing charity, and the only way other charities can benefit is for the issuing charity to make grants to them.

? The trust can last for the lifetime of named beneficiaries or for a term of years. A CGA cannot be for a term-of-years. Rather, payments must be made for the lifetime of one or two individuals.

? The donor can select a trustee to handle investment of trust assets, whereas the charity makes all investment decisions regarding CGA reserves.

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? A charity is not exposed to financial risk in being named as a remainder beneficiary, though it is accountable as a fiduciary if it acts as trustee.

? Payout rates are determined by the donor and the trustee, subject to IRS requirements, and are not age-based.

? The sometimes-onerous state regulations imposed on charities that issue gift annuities do not apply to charitable remainder trusts.

? The donor is not subject to up-front taxation of gain if appreciated property is contributed and someone other than the donor is a beneficiary. In the case of a CGA, the donor is taxed on the gain allocated to the present value of the annuity in the year of the gift.

2. Advantages of a gift annuity.

? Payments are fixed and unaffected by fluctuations in stock values and interest rates.

? The payments are backed by all of the assets of the charity, so annuitants can rely on payments unless the charity becomes insolvent. If trust assets should be exhausted, income beneficiaries would receive no more income.

? Charities generally will accept relatively small contributions for a CGA. A common minimum contribution is $10,000. For a trust to be practical the contribution probably should be $200,000 or more. (Some charities that act as trustee might accept as little as $100,000 for a trust, but a corporate trustee may set the minimum at $500,000.)

? A CGA is inexpensive to establish. Generally, the donor pays nothing except fees for consultation with professional advisors about the advisability of the gift. On the other hand, establishment of a charitable remainder trust could cost several thousand dollars, depending on the complexity of the trust agreement and who drafts the agreement.

? If the donor contributes cash, there will probably be more tax-free income with a CGA than with a charitable remainder trust.

? Gift annuities are easy for donors to understand. A charitable remainder trust is more versatile but also more complex.

D. Security Versus Growth Potential

An advantage of a CGA is that payments never go down. A disadvantage is that they never go up. Because they do not increase, they will lose purchasing power

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over time. While CRUT income may keep pace with inflation, it can also decline sharply in a bear market.

Suppose, however, that the contribution would be large enough for either a CGA or a charitable remainder trust. Which is preferable? The following graphs show how cash flow would have compared in the case of charitable remainder unitrusts and gift annuities established, respectively, on January 1, 1992 and January 1, 1998.

In the case of the CRUT, assets are presumed to be invested 60 percent in equities (S & P 500) and 40 percent bonds (Lehman Brothers U.S. Aggregate Index) with constant rebalancing. In the case of the CGA, the rates are those recommended by the ACGA at the time.

Unitrust and Gift Annuity Established January 1, 1992, 65-year-old Payments shown for 12 years

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Unitrust and Gift Annuity Established January 1, 1998, 65-year-old Payments shown for 12 years

100,000 90,000 80,000 70,000 60,000 50,000 40,000

Unitrust Annuity

Under active management and with different asset allocation, the CRUT may have fared better than shown in these graphs.

E. How a Gift Annuity Can Be Designed to Provide Inflation Protection As Well As Security

The CRUT can offer a chance to keep pace with inflation but as we have seen, the CRUT is subject to market fluctuations. Therefore, while there is a possibility of inflation protection, payments will actually decline if the market contracts. Donors may be attracted to a plan that combines the security of fixed payments with periodic increases in cash flow. By combining a series of gift annuities that begin making payments over a range of start dates, a donor can enjoy the safety of fixed, guaranteed payments with an increasing cash flow. A donor can create in one sitting a series of deferred gift annuities that will begin making payments on staggered start dates. Alternatively, the donor can bundle an immediate gift annuity with a number of deferred gift annuities that have successively later payment start dates.

While it may be possible to draft a single gift annuity agreement that contains all of these provisions, the more prudent course is to execute simultaneously multiple agreements that differ only in the timing and amount of payments. Administratively, the issuing charity would issue a single check using whatever

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